Criteria For An Effective And Socially Just EU ETS 2 - Germanwatch

Assessment of the EU Commission’s Proposal on an EU ETS 2 Page 5 of 48 E: GEWÄHRLEISTUNG EINER FAIREN LASTENTEILUNG ALLER SEKTOREN Bei den Akteuren, die die Kosten der Transformation zur Klimaneutralität tragen, ist ein Ungleichgewicht zwischen den Sektoren festzustellen. So sollen im EU ETS 2 alle Zertifikate versteigert und damit tatsächlich bezahlt werden (vor allem von Haushalten), während sie im EU ETS 1 noch überwiegend der energieintensiven Industrie frei zugeteilt werden. Das untergräbt das Verursacherprinzip und senkt die gesellschaftliche Akzeptanz gegenüber dem Emissionshandel. Die Einführung eines CO2-Grenzausgleichs (Carbon Border Adjustment Mechanism, CBAM) und die geplante Reduzierung der kostenlosen Zuteilung sind zentrale Schritte zum Abbau dieses Ungleichgewichts. Es sollten weitere Schritte in diese Richtung unternommen werden mit dem Ziel, so schnell wie möglich von der kostenlosen Zuteilung zur Versteigerung überzugehen. Mit der Ausweitung der CO2-Bepreisung auf die Sektoren Gebäude und Straßenverkehrs wäre ein Großteil der Emissionen der EU vom Emissionshandelssystem abgedeckt. Die Einbeziehung weiterer Sektoren und Bereiche könnte erwogen werden (z. B. Kleinindustrie und nichtelektrischer Schienenverkehr). Das deutsche nationale Emissionshandelssystem (nEHS) für Heizund Kraftstoffe beispielsweise zeigt, dass eine Erweiterung möglich ist. F: ANPASSUNG IMPLIZITER UND EXPLIZITER CO2PREISE DER CO2UND ENERGIE-BESTEUERUNG Um einen kohärenten Policy-Mix und konsistente Preissignale sicherzustellen, muss die explizite und implizite CO2-Bepreisung (durch EU ETS 1 und 2 sowie Energiebesteuerung) aufeinander abgestimmt werden. Die von der Europäischen Kommission vorgeschlagene Überarbeitung der Energiesteuerrichtlinie würde dazu beitragen. Sie schafft darüber hinaus Raum für die Berücksichtigung sozialer Belange durch die Ermöglichung gezielter Steuersenkungen und befristeter Ausnahmen. Die Kommission sollte sollte Wege finden, um die Mitgliedstaaten dazu zu bringen, ihr bereits bestehendes CO2-Preisniveau aus impliziter und expliziter Bepreisung als Reaktion auf die Einführung des EU ETS 2 nicht abzusenken. Forschungsstätte der Evangelischen Studiengemeinschaft e.V. Forum Ökologisch-Soziale Marktwirtschaft e.V.

Assessment of the EU Commission’s Proposal on an EU ETS 2 Page 6 of 48 1 Overview of the Assessment In early 2021, the European Union set the objectives of reducing net emissions by at least 55% by 2030 compared to 1990 and thus of achieving climate neutrality by the year 2050. On July 14th 2021, the European Commission (2021) presented a series of legislative proposals in line with the “Fit for 55” package, which include raising the targets of the two main EU instruments: the EU Emissions Trading System and the Effort Sharing Regulation (ESR). The Commission proposed to increase the target from 43% to 61% (compared to 2005) for sectors covered under the existing EU Emissions Trading System (henceforth: EU ETS 1). With regard to sectors covered by the ESR, the former target of cutting emissions by 29% is supposed to increase to 40%, compared to the levels in 2005. For the buildings and road transport sectors within the ESR, the Commission has put forward a reduction target of 43% by 2030 relative to 2005. In line with stronger climate action, the Commission’s proposal includes introducing a separate emission trading system for buildings and road transport (henceforth: EU ETS 2). Implementing an emission trading system for buildings and road transport in the EU could be a useful complementary instrument for several reasons (conditional on the criteria in Table 1): 1. Putting a price on carbon introduces the polluter pays principle – hence, those who produce pollution bear the costs of paying for the damages done to the climate and environment. 2. A cap on carbon can establish a transparent trajectory that reaches the 2030 reduction target cost- efficiently via clear quantity control and limited release of predefined auction volumes to the market. 3. Pricing carbon can open investment channels for low-carbon alternatives in the buildings and road transport sectors (i.e., reduced risks and costs for investors). 4. Revenues from auctioning allowances can be used to compensate low-income groups and businesses within Member States and reward those who emit less. 5. Unlike national instruments, the equitable distribution of auctioning revenues among Member States has the potential to mitigate economic and social inequalities and rewards those Member States that are climate leaders in the EU (given that the necessary mechanisms are implemented accordingly). The Commission’s initiative promises improved climate action in the European Union. Nevertheless, it is essential to consider multiple sector-specific characteristics for pricing emissions in the buildings and road transport sectors successfully. Despite similarities with the EU ETS 1, marginal abatement costs and distributional burdens differ substantially between covered sectors. In light of this background, this paper investigates central aspects of the Commission’s proposal for the EU ETS 2. It discusses criteria which should be applied in the event of the introduction of an EU ETS 2 to obtain effective and socially just carbon pricing during the ETS initial phase and the later stages (see Table 1). Table 1: Criteria for an effective and socially just EU ETS 2 Criterion A: EMBED CARBON PRICING WITHIN A HOLISTIC POLICY MIX Assessment and recommendations The current climate policy mix is not sufficient for achieving climate targets. Additional measures have to be taken, and carbon pricing could be a useful complementary instrument in a policy mix. Strengthening carbon pricing and internalising climate costs can accelerate EU climate action as part of a holistic policy mix. The EU ETS 2 should be implemented as a backstop instrument, indicating the (in-)effectiveness of other climate policies via its function as “warning indicator”. It should be considered as complementary to performance standards, public investments, and other market-based instruments. Moreover, it must not replace the Effort Sharing Regulation (ESR) as the core compliance instrument. The proposal of the EU Commission identifies the role of the EU ETS 2 very clearly in this regard. Forschungsstätte der Evangelischen Studiengemeinschaft e.V. Forum Ökologisch-Soziale Marktwirtschaft e.V.

Assessment of the EU Commission’s Proposal on an EU ETS 2 Page 7 of 48 B: SAFEGUARD THE EFFECTIVENESS OF THE EU ETS 2 Introducing an EU ETS 2 strengthens European climate action - it ensures that the 2030 targets are met by setting a distinct cap and reduction path. In political practice, however, emission trading systems are usually subject to (meaningful) interventions (e.g., via the frontloading mechanism). This can be useful, yet frontloading allowances means “borrowing” from future carbon budgets and ultimately postpones emission reductions. It might also lead to very low carbon prices. In order to guarantee effectiveness, we propose the introduction of a steadily increasing price floor; at least until the effects of frontloading are predictable, and prices in the EU ETS 2 are less volatile. The price floor would help to retain ecological effectiveness by preventing the price from dropping below predefined levels and, if set sufficiently high, still sends a credible signal to investors to finance low-carbon projects and technologies. C: ENSURE JUST DISTRIBUTION BETWEEN MEMBER STATES The proposed Social Climate Fund (SCF) would redistribute substantial amounts of auction revenues to low-income Member States. However, the ways in which the distributional effects between Member States will develop in the future remain unclear, as they strongly depend on future GHG reductions, and how the latter differ between Member States. This aspect should be investigated in more detail in further analyses, on the basis of which the decision on whether further solidarity mechanisms should be introduced should be made. However, since the redistribution through the SCF can already be classified as relatively extensive, the overall assessment for this criterion is quite positive. In principle, the proposal offers appropriate solutions to achieve a socially acceptable pricing of carbon emissions for EU citizens. It proposes to redistribute revenues to low-income households and to help them reduce their carbon emissions. The proposed funding via the SCF could (in theory) be sufficient to mitigate severe distributional consequences. However, the design and thus the effectiveness of the SCF remains unclear. The Commission should therefore specify the design of the proposed redistribution mechanisms. D: ENSURE SOCIAL ACCEPTABILITY FOR HOUSEHOLDS In addition, the criteria and requirements imposed on the Member States with regard to the use of the allocated funds should be developed further. The creation of appropriate governance structures should be encouraged and supported accordingly, so as to make possible targeted and effective relief for poor and particularly affected households. Given that uncertainties concerning the distributional effects will remain, we further propose the introduction of an (increasing) explicit price ceiling, enforced via the MSR, and of a warning price, which would be below the maximum price and upon which direct increased efforts and measures to reduce carbon emissions by the EU and its MS should follow. If analyses after the introduction of the EU ETS 2 show that social acceptability is ensured, the price ceiling could be raised (more quickly) and potentially abolished completely. E: ENSURE FAIR CONTRIBUTION OF ALL SECTORS An imbalance can be found with regard to the actors bearing the costs of the transformation towards climate neutrality between sectors. That is, in EU ETS 2 all allowances are to be auctioned and thus actually paid for (mainly by households), whereas in EU ETS 1 they are still allocated freely to the energy-intensive industry most of the time, which undermines the polluter pays principle and thus lowers and endangers the acceptance for emissions trading. The introduction of a Carbon Border Adjustment Mechanism (CBAM) and the planned reduction of free allocation are pivotal steps to reduce this imbalance. Further steps in this direction should be taken. The goal should be to switch from free allocation to auctioning as swiftly as possible. Forschungsstätte der Evangelischen Studiengemeinschaft e.V. Forum Ökologisch-Soziale Marktwirtschaft e.V.

Assessment of the EU Commission’s Proposal on an EU ETS 2 Page 8 of 48 With the inclusion of road traffic and buildings, a large part of the EU's carbon emissions not yet covered by the EU ETS would be included. However, further consideration could be given to including additional sectors and areas (e.g., small industry and non-electric railroad). The German National emissions trading system (nETS) for heating and transport fuels, for example, shows that an extension is possible. F: ALIGN IMPLICIT AND EXPLICIT CARBON PRICING INSTRUMENTS LIKE CARBON AND ENERGY TAXES In order to ensure a coherent policy mix, explicit and implicit carbon pricing through EU ETS 1&2 and energy taxation have to be aligned in order to create coherent price signals. The revision of the Energy Tax Directive as proposed by the European Commission would lead to improved consistency between explicit and implicit carbon prices. It also creates room for addressing social concerns via targeted tax reductions and temporary exemptions. The Commission should find ways to oblige Member States not to lower their overall carbon price levels (implicit plus explicit) in response to the introduction of EU ETS 2. Forschungsstätte der Evangelischen Studiengemeinschaft e.V. Forum Ökologisch-Soziale Marktwirtschaft e.V.

Assessment of the EU Commission’s Proposal on an EU ETS 2 Page 9 of 48 2 Analysis of the individual criteria 2.1 Criterion A: Embed carbon pricing within a holistic policy mix 2.1.1 What is it about? The current climate policy mix is not sufficient for achieving the climate targets of the EU and its Member States (MS). Additional measures will have to be taken, and carbon pricing could be a useful complementary instrument in a policy mix - also considering the buildings and road transport sectors.1 In theory, carbon pricing can be a central instrument by addressing the “largest market failure the world has ever seen” (Stern 2008). Putting a price on carbon (or internalizing external climate costs) is a theoretical "first-best" response to the climate crisis from an economic point of view. It ensures cost-effective emission reductions. Emissions will be avoided for cases in which it is cheapest to do so, and economic decisions will be optimized with respect to climate costs (Figure 1). Polluters receive an immediate financial incentive to exploit all abatement opportunities to reduce their emissions.2 well as economic and social shortcomings (IMF 2019). For example, carbon pricing is ineffective if low-carbon alternatives are missing or if prevailing market structures are too dominant. It cannot initiate transformation without strategic high cost-high risk and infrastructure investments (which private markets usually do not deliver; Figure 1). Additionally, behavioural obstacles tend to prevail, given that real people tend to not be as rational as economic theory would like to assume. Hence, standards, rules and regulations are necessary. Lastly, carbon pricing needs political long-term credibility to have a persuasive signalling effect. Economic efficiency and market forces do not necessarily yield socially acceptable outcomes, which makes compensatory measures indispensable to ensure support from the population. However, this becomes effective solely within a holistic policy mix, which addresses theoretical and practical as Figure 1: Three pillars of economic policy Source: based on Grubb, Hourcade, and Neuhoff. (2014): Planetary Economics: energy, climate change and the three domains of sustainable development. Routledge 2.1.2 What is the proposal by the European Commission? The Commission’ proposal outlines the idea of a holistic and balanced policy mix to achieve the national targets for emission reductions from road transport and heating of buildings as specified in the Effort Sharing Regulation (ESR). In line with existing evidence, it argues that over-reliance on regulatory policies increases burdens for economic actors and creates additional investment challenges. On the other hand, focusing merely on economic incentives via price signals could imply excessive carbon prices, whereby carbon pricing alone would not overcome persistent market failures and non-market barriers. In turn, the Commission suggests that the optimal policy mix should complement price instruments, such as the EU ETS 2, with regulatory policies (e.g., on energy efficiency and performance standards for vehicles). The European Green Deal provides substantial financial means for investing into the green and social transition. 1 . see e.g. https://zenodo.org/record/5562910#.YW7GcBxCSUl Forschungsstätte der Evangelischen Studiengemeinschaft e.V. Forum Ökologisch-Soziale Marktwirtschaft e.V.

Assessment of the EU Commission’s Proposal on an EU ETS 2 Page 10 of 48 2.1.3 Assessment and Recommendation The EU ETS 2 should not be considered as the main policy instrument to mitigate carbon emissions and achieve the climate targets. Its role can be found within a holistic policy mix instead and should be regarded as a warning indicator and backstop instrument that aids to achieve national targets under the ESR: ESR targets remain the overriding goal and EU ETS 2 is meant to help Member States reach these targets. Complementary policies and measures include the Energy Efficiency Directive, Renewable Energy Directive, CO2 standards for cars and vans, as well as the Alternative Fuels Infrastructure Regulation. EU ETS 2 is a “warning indicator” (see Criterion D), because high price levels indicate the (in-)effectiveness of other measures in the policy mix. Eve

Im Vorschlag der EU-Kommission wird die Rolle des EU ETS 2 in dieser Hinsicht sehr klar eingeordnet. B: SICHERSTELLUNG DER WIRKSAMKEIT DES EU ETS 2 Die Einführung eines EU ETS 2 stärkt die europäischen Klimamaßnahmen - es stellt sicher, dass die Ziele für 2030 erreicht werden, indem es Emissions-obergrenzen und einen Reduktionspfad festlegt.